Misleading company accounts

This is the first of two articles about recent problems with accounting and auditing and considers factually what went wrong with the accounts of Carillion and Patisserie Valerie. The second considers audit and how the system of incentives may have played a part in auditors apparently not detecting when accounts are materially wrong.

A year after the compulsory liquidation of the construction and outsourced contracts provider Carillion it was the turn of cake chain Patisserie Valerie to collapse last month. According to their most recent annual financial statements both companies were profitable and both had reported rising profits and rising sales. The accounts of both companies suggested they were in good financial health with rosy prospects and the audit reports were both unqualified. So how come they both collapsed?

Carillion’s accounts for the year ended December 2016 were issued in March 2017. It boasted a strong order book, financial strength, high standards of corporate governance and accountability, a responsible culture and a highly effective board. The company also claimed strong risk management and the directors confirmed that they had “carried out a robust assessment of the principal risks facing the Group, including those that would threaten its business model, future performance, solvency or liquidity“. They said “on the basis of both reasonably probable and more extreme downside scenarios, the directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment.” The report confirmed the Audit Committee had “reviewed the Group’s Annual Report and Accounts and recommended them to the Board as representing a fair, balanced and understandable assessment of the Group’s position”.

A few months later in July 2017 a ‘trading update’ issued to the London Stock Exchange reported “an unexpected contract provision of £845m”. In layman’s language this meant a loss. The loss wiped out all the group’s retained earnings and turned what had been the accounting value of its net assets at 31 December 2016 of £729m into a net liability of £116m – meaning in balance sheet terms that the company was worse than worthless. By 29 September, in its interim statement on the results to 30th June, further losses were reported taking the net liabilities to £405m. Nevertheless the Group reported that it was “compliant with its (banking) covenants at 30 June 2017 and is forecast to be in compliance with covenants as at 31 December 2017 and 30 June 2018”and that “taking account of the projected trading for the Group over the remainder of the year and the additional bank facility, the Board has a reasonable expectation that the Company and the Group will be able to operate within the level of its available facilities and cash for the foreseeable future”. Other parts of the trading update (which is also known as a profits warning) and the interim statement were upbeat about the group’s prospects and gave no hint of immanent failure. By January 2018 Carillion was so bust the Government had to pay the liquidator.

The subsequent Parliamentary joint inquiry by the Business, Energy and Industrial Strategy and the Work and Pensions Committees revealed that both the directors and the external auditor had been taken by surprise by both the need to make the contract provision and by the company’s subsequent failure. It was clear that governance was poor, the board was ineffective, the financial statements misleading and the claims about risk management and the group’s viability for the next three years were wrong. The inquiry report said “in failing to exercise professional scepticism towards Carillion’s accounting judgements over the course of its tenure as Carillion’s auditor, KPMG was complicit in them”.

Unfortunately, the inquiry did not reveal how or why they were so wrong. The UK corporate governance system confers much of the initial responsibility for the financial statements and risk management on audit committees while leaving the board as a whole ultimately responsible. It was a pity that the inquiry did not ask Carillion’s audit committee members to give evidence. We do not know whether they were simply inept, failing to understand the significance of what the committee claimed it considered, failed to investigate where it should have been curious, dishonest in the statements made or whether there is a wider problem. The wider problem being whether expecting audit committees to ensure accounts are reliable and risk management effective is just too big an ask for them.

There is unlikely to be a Parliamentary inquiry into Patisserie Valerie. Unlike Carillion it has not left tens of thousands without jobs, a £2.6 billion hole in the pension fund, £2 billion owed to 30,000 suppliers, £1 billion owed to banks or government contracts in turmoil. So we know less about what happened. We do know that on 10th October 2018 Patisserie Valerie announced to investors that the board had “been notified of significant, and potentially fraudulent, accounting irregularities and therefore a potential material mis-statement of the Company’s accounts“. This, it said, had “significantly impacted the Company’s cash position and may lead to a material change in its overall financial position”. As a result the company requested that its shares be suspended from trading on AIM while it conducted a full investigation with its legal and professional advisers into its true financial position. Two days later the company said it required an immediate cash injection of £20 million without which there was no scope for the Group to continue trading in its current form. Its chairman and major shareholder, Luke Johnson, a highly successful investor and entrepreneur, would loan the company £20m while fresh capital was being raised. Further finance would be required and various reports suggested a black hole of £40m.

In mid January the company reported that work carried out by the forensic accountants had revealed that the misstatement of its accounts was extensive, involving very significant manipulation of the balance sheet and profit and loss accounts and thousands of false entries into the Company’s ledgers. A week later the company was unable to renew its credit facilities and as a result was put into administration. Ironically, perhaps, Johnson in September 2018, a month before the fraud was revealed, had written a column ‘A business beginner’s guide to tried and tested swindles’ in the Sunday Times. He called it an aide-memoire for those looking to spot the next fraud. How could such a financially experienced person have been taken by surprise by what seems to have been a large scale fraud in a company he owned part of and whose board he ran?

The next article will discuss why audits may fail to alert people to massive misstatements in a company’s annual accounts.

Written by Paul Moxey, SAMI Fellow and a chartered accountant and fellow of ICSA – the Governance Institute. He is also Visiting Professor of Corporate Governance at London Southbank University, a Fellow of SAMI Consulting and author of a text book on corporate governance published by ICSA. In the past he has been both an external auditor and the CFO and company secretary of a listed company and responsible for the preparation of reliable accounts.

The views expressed are those of the authors and not necessarily of SAMI Consulting.

SAMI Consulting was founded in 1989 by Shell and St Andrews University. They have undertaken scenario planning projects for a wide range of UK and international organisations. Their core skill is providing the link between futures research and strategy.

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